SF CDOs brave historic tights

With collateral spreads historically rich, some ABS CDOs might never make it through the starting gate, especially if nearing the end of their investment periods, industry sources said. At the very least, the market is less likely to see upsized deals in early 2004, which was a frequent occurrence in the sector throughout 2003. In fact, it is possible some deals will reduce in size.

For deals that began purchasing collateral last fall, there may be incentive to dump the assets now and take the gains. "If everyone dumped at once, that could flood the market," one investor said. "The first one out will probably do well, because spreads are at all-time tights, but there would be a point where an equilibrium is reached."

The market saw a glimpse of this situation in November, when two CDOs of CDOs unwound their positions allegedly because of spread tightening (see ASR 12/1/03). The result was a $500 million liquidation of triple-A and double-A CDO tranches.

The pipeline of multi-sector CDOs is still fairly robust, mostly concentrated in the residential ABS sectors. Sources are quick to note, however, that liability spreads, which have typically lagged collateral, have shown improvement recently. Independence CDO V, for example, saw its senior triple-A come in eight basis points from guidance, to price at 40 over three-month Libor. Five basis points of tightening was seen on the double-A B class as well, which priced at 115 over three-month Libor. Merrill Lynch underwrote the transaction.

Since the start of the year, spreads on SF CDOs have tightened three basis points on triple-A seniors, five basis points on the triple-A juniors and 15 basis points on double-A subs, according to UBS research.

Data from Banc One Capital Markets shows that triple-B floating-rate home equity bonds, generally a favorite of CDOs, have traded as wide as 385 basis points over one-month Libor in the past year, compared with current levels of about 175 basis points, and have come in 40 basis points since Jan. 1. Year-to-date, triple-B-minus five-year home equity subs have come in 250 basis points, by Banc One's numbers.

To counter the crunch, several recent CDOs have funded partially in the ABCP market, with short-term issuance vehicles built into the deals. For example, the recent Millstone Funding transaction, via Citigroup Global Markets, included an $880 million money market tranche, which funds in the CP market, with the ability to roll over paper as if it were a conduit. Using the short-term market to separate the funding from the credit risk cheapens the all-in cost of funds.

Also, SF CDOs are looking at other sectors and other notches of the capital structure. "We're seeing a general movement towards other collateral," a rating agency source said.

Negative connotations

Despite an incentive to take gains, there are negative associations with pulling a deal from market, for both underwriters and repeat-issue collateral managers. "CDO managers may feel that they want to be in the market, they want to have a deal, they want to have a new issue, and they don't want to take a hiatus," said Douglas Lucas, head of CDO research at UBS. "I think most CDO managers would rather issue a smaller CDO than take a hiatus from the market."

That said, whether or not to liquidate pre-closing is probably as much, or more, the underwriter's decision than it is the collateral manager's. For one, the underwriter is generally warehousing the assets. "The question would be, Who gets what if you go unwind the portfolio?' " remarked a buyside source.

While pulling a deal from market might not be the desirable option for reasons of reputation, banks and collateral managers would also consider the negative association tied to a CDO that has a dramatic change in its equity profile. Ultimately, it will come down to the individual economics of each deal, as the arrangements vary. A downsize is also possible, where, at closing, "investors are asked to write smaller checks," commented Jeremy Gluck, of the CDO group at Moody's Investors Service.

"It would not enhance an underwriter's representation if they either had to pull a deal or downsize a deal," Gluck added. "It's an underwriting function to get the deal done with the anticipated execution."

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